I thought the following would be of interest to you exchangers out there.
One of the biggest overlooked deductions when real estate is exchanged is the unamortized mortgage financing costs attached to the property. Since property exchanged is treated as property sold for purposes of deducting loan costs, let’s review this important deduction. The cost of acquiring a mortgage loan can be substantial. The first cost is getting the loan. The other cost is interest.
Borrowers incur substantial fees and charges when a mortgage loan is funded. These costs include legal fees, points, appraisal fees, escrow fees, service charges, surveys, and title costs. Costs that do not qualify as interest are treated as lending service costs. If the mortgage was obtained to acquire real estate used in business or held for profit, the costs are deductible by amortizing them over the life of the loan.
The term “points” is used to describe the interest charges you pay as a borrower to a lender when you take out a mortgage. Lenders have different names for points: loan origination fees, premium charges, etc. But what they call them doesn’t matter. If the payment for any of these charges or points is for the use of money, it is interest.
Costs that qualify as interest are treated as prepaid interest – capitalized and amortized straight-line over the life of the loan. If there is a balance in the unamortized loan costs account, and the loan is paid off or assumed, the tax treatment of the balance depends on the classification of the property. In cases of Section 1031 property, (real estate used in a trade or business such as rental income property), the entire balance is deductible as an operating expense of the property in the year the property is sold or exchanged.
Here is an example: Ten years ago you bought an apartment building from Glenn, The Apartment Broker, and paid loan costs of $40,000 to acquire the 25-year mortgage loan. You now sell the rental property as part of a 1031 exchange set up with your Qualified Intermediary. During the last ten years, you deducted your loan costs by amortizing them at the rate of $1,600 per year ($40,000/25 years). Your deduction totaled $16,000 for the ten years ($1,600 per year times 10 years). The unamortized balance of $24,000 is deductible at the time of the exchange on Schedule E as an operating expense of the property. Remember, this is an ordinary deduction against ordinary income in the year you exchange the property. Be sure your tax person does not overlook it – many do and it disappears into the abyss, never to be seen or used again. Like the old saying goes, use it or lose it.
Until next time, Glenn Sather
